Question

12/07/19

use your own words

2. What is the concept of operating leverage? Describe a scenario where a high degree of operating leverage would be positive for a company and one in which it would be negative.

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Answer 1

Operating Leverage

Operating leverage is a cost-accounting formula that measures the degree to which a firm or project can increase operating income by increasing revenue. A business that generates sales with a high gross margin and low variable costs has high operating leverage.

The higher the degree of operating leverage, the greater the potential danger from forecasting risk, where a relatively small error in forecasting sales can be magnified into large errors in cash flow projections.

High and Low Operating Leverage

It is important to compare operating leverage between companies in the same industry, as some industries have higher fixed costs than others. The concept of a high or low ratio is then more clearly defined.

Most of a company’s costs are fixed costs that recur each month, such as rent, regardless of sales volume. As long as a business earns a substantial profit on each sale and sustains adequate sales volume, fixed costs are covered and profits are earned.

Other company costs are variable costs that are only incurred when sales occur. This includes labor to assemble products and the cost of raw materials used to make products. Some companies earn less profit on each sale but can have a lower sales volume and still generate enough to cover fixed costs.

For example, a software business has greater fixed costs in developers’ salaries and lower variable costs in software sales. As such, the business has high operating leverage. In contrast, a computer consulting firm charges its clients hourly and doesn't need expensive office space because its consultants work in clients' offices. This results in variable consultant wages and low fixed operating costs. The business thus has low operating leverage.

• Companies with high operating leverage must cover a larger amount of fixed costs each month regardless of whether they sell any units of product.
• Low-operating-leverage companies may have high costs that vary directly with their sales but have lower fixed costs to cover each month.
• The operating leverage formula can show how a company's costs and profit relate to each other, and show that reducing fixed costs can increase profits without changing sales quantity, contribution margin or selling price.